Insurance Industry Analysis

Introduction
The industry on which this paper will focus is the insurance industry, which has the NAICS code of 524133. The insurance industry is divided among a number of subsections. These subsections function roughly the same way. An insurance company identifies the risks associated with something, and then offers up insurance against the negative event. The customer pays the insurance company based on what the insurance company expects to pay out, plus whatever markup the insurance company pays. The basic premise is that if the insurance company prices risk properly, it will be profitable, but if it misprices risk, it will not be profitable.
Critical Problem
The insurance industry's critical problem is pricing risk. There are a few interesting elements, though. One is that the insurance business is heavily regulated, and that can create specific situations that challenge the firms in the industry. An example would be the uncertainty that surrounds the fate of the ACA. The ACA was passed, and insurance companies knew the operating conditions, but then then new administration has called into question if the ACA will continue to survive. This regulatory uncertainty is an issue that challenges insurance companies, because they rely on math to determine their profitability, and when there are variables where there should be certainty, such as with respect ot the legal environment, this can be incredibly challenging for insurance companies.
Importance of Solving the Problem
The insurance industry relies on mathematical equations in order to offer a product that risk averse people value. These mathematically challenged individuals fail to realize the insurance companies are a casino that always wins – they offer the sense of security at a price that allows them to know they will always come out ahead. For companies that want to minimize downside risk, insurance has a lot of value, so they pay. The reality is that the downside risk of things like fire, or natural disasters, is catastrophic in nature. Thus, businesses will typically be willing to pay to protect themselves against any type of risk that is catastrophic in nature, and it is this specific vulnerability that insurance companies exploit in order to earn their profits.
Changing regulations at any level of government creates a challenge for insurance companies. They run their business based on historical data that tells them the odds of certain events. Changes in regulations can change the likelihood of the events that they are defending against, the cost to insure against those events and other variables. No doubt there is fairly intense competition among the major insurance companies, but overall those companies are not hurting for business. The real threat comes from changes in legislation that might change the math upon which insurance companies rely to establish their pricing. When pricing is misaligned with risk, insurance companies cannot profit.
Central Theme
The central theme of this paper is to examine profitability in the insurance sector, relative to the different drivers of profitability that exist. Elements like market structure, conduct and profitability will be discussed.
Importance of Resolving the Problem
Uncertainty is basically the enemy of the insurance industry, which creates an imperative to resolve the problem. The reality is that insurance companies look at massive data sets in order to set their rates. To do so requires that past performance needs to be at least a somewhat reliable indicator of future performance. In the case of many insurance businesses, this is not the case. The math relies on being able to apply numbers consistently, and that will simply not happen when there is poor data. Thus, whenever the rules change in the insurance industry, there are problems for the companies that exist in this industry. When rules change dramatically, they can result in changes to the pricing which in turn will create substantial problems for the insurance business with respect of being profitable. So there are some fairly strong reasons why it is challenging to run an insurance company.
To overcome this challenge requires some activity on the lobbying level. The reality is that the insurance business is quite mature, and the biggest gains will come through lobbying that changes the math. Everything else – mastering pricing, lowering costs, and that sort of thing, are really just incremental gains. Changing the math is what really matters.
Macroeconomic Issues
Macroeconomic issues don't matter all that much. The insurance industry, for most customers, is viewed as non-discretionary. There are certain insurance companies that do seem to be more discretionary in nature, and those would be more affected by changes in the macroeconomic environment. The macroeconomic environment is important in terms of understanding how the business will in general, though. If there is a recession, for example, that will result in fewer companies that exist, which means that fewer companies need insurance. All told, that's not good for insurance companies. So while there isn't a whole lot of non-discretionary component to insurance spending, a health economy still has its benefits.
Market Structure Conduct and Performance
The link between market structure, conduct and performance is fairly straightforward. In a monopoly, firms will generally seek to abuse monopoly to increase profits. In an oligopoly, firms will compete against each other. If there is no collusion, tacit or otherwise, firms will lose money in an oligopoly because of the strength of their competitive responses to each other. In a state of monopolistic competition, firms will typically seek to differentiate themselves from their competitors as a means of establishing a point at which they can profit. Firms in a state of perfect competition will price in line with competitors, will be unable to differentiate and thus will be unable to earn profit.
The insurance business is in a state of monopolistic competition, but has strong tendencies towards perfect competition. First, the product is basically undifferentiated. Backed by the same math, the reality is that insurance companies offer roughly the same products at roughly the same prices. They might seek to differentiate on brand name, or customer service, but the reality is that there is little in the way of meaningful differentiation among insurance companies. As such, most seek to compete on slim differentiators - slight distinctions in terms of price or in terms of what the company is willing to offer. At the end of the day, this presents a challenging environment in which insurance companies operate.
Price Above Marginal Cost
Insurance companies are usually profitable, if even just a little bit. By design, the seek to price just above marginal cost. This allows insurance companies to earn a profit on each policy. The profit is usually quite slim, but this allows the company to earn a profit over the course of thousands or even millions of policies. This approach to business accepts that there will be differences in terms of cost inputs, but also reflects the need of the company to compete against other insurance companies that have more or less similar data sets.
Increased Size
The insurance industry has grown steadily, but has not increased at any special rate. It serves the entire economy and therefore generally tracks growth in the economy as a whole.
Performance
In the long run, insurance is always profitable. The reason for this is simple – insurance companies have information asymmetry. They know the number – the odds – that they use as the basis for their pricing. Their consumers typically do not. As a consequence, insurance companies will grow over time, because the specifically and deliberately price to be profitable. All told, insurance is a very stable, profitable business. There are few highs – competition keeps pricing in line – but there are few lows either, because the underlying math behind each policy more or less insures that over a broad sample size, the insurance company will always win. Insurance is a casino where the house always wins – the only way you win is if something horrible happens, which is quite the Pyrrhic victory. Ultimately, insurance companies win and their customers lose –unless there is a particular value placed on peace of mind, and even then you'd have to trust that the insurance company will pay out, which they will probably fight because that's how they squeeze out extra margin.